Does inflation impact a DCF valuation? How? We need to go back to the basics of a DCF valuation to understand the answers to these questions.
The bottom line is that you’ll want to use nominal cash flows instead of inflation-adjusted “real” cash flow estimates. It’s a minor detail, but could tip the scales on every valuation you ever do.
Back to the Basics: DCF Model
A DCF, or Discounted Cash Flow, model is a formula to estimate the value of future free cash flows discounted at a certain cost of capital to account for risk, inflation, and opportunity cost.
The riskier the investment, the higher you discount the cash flows.
The more that there are better alternatives for investment (opportunity cost), the higher you discount the cash flows. (This is why discount rates are so low today; risk-free returns and the returns on strong corporate bonds are painfully low.)
And finally, the more that you expect inflation—or to put it another way, the more that you expect that future free cash will be less valuable than today—the more you discount the cash flows.
Because if cash flows are worth significantly worth more today than in the future, then you have significantly more spending power today than in the future. So, you’ll need higher returns in the future to maintain a similar spending power for those future cash flows.
However, you don’t factor inflation into a discount rate, but instead take care of it organically as part of a DCF.
Let me explain.
And let’s go back to the basics of inflation.
Real Cash Flow vs Nominal Cash Flow
There are two key terms to remember with inflation: you have “nominal” and “real.” So you have nominal cash flows and real cash flows, nominal (GDP) growth and real (GDP) growth, and nominal returns and real returns.
- Nominal refers to non-inflation adjusted figures.
- Real refers to inflation adjusted figures.
This can be greatly misunderstood, even among talented and smart analysts.
You see this misunderstanding with stock market returns also.
Some people quote the market as having an average of 7% annual returns, while some quote the market as having an average of 10% annual returns.
Both are correct, but the key is in nominal vs real.
The stock market has had 7% real returns, while it has also had 10% nominal returns—as inflation has averaged around 2-3% a year.
Finally, there’s a key difference in using a DCF on a real vs nominal basis.
Most DCFs are calculated on nominal cash flows.
To quote one of the greatest teachers on valuation, Professor Aswath Damodaran from NYU Stern:
So we have to keep in mind that the discount rate we choose to use, whether it’s a real rate or nominal rate, sets the tone for the rest of the DCF model.
That includes the growth rate projection for the free cash flows, and the GDP component if you’re using one (which is often used for terminal value).
That begs the question…
Are most discount rates nominal or real?
Real Discount Rate Vs Nominal Discount Rate
Many analysts use the WACC, or Weighted Average Cost of Capital, as their discount rate. This involves using a risk-free rate, and beta, and the cost of debt.
Let’s think about if each of these components are nominal or real.
Note that if you look up the real yield for the 10 year and 30 year treasury for 2020, it has been negative since March.
In most of the economic reporting I’ve seen, they’ve been reporting the 10y and 30y at below 1 since the same time period, which is the nominal rate.
So our risk-free rate is nominal.
The cost of debt is also nominal.
When these public corporations issue bonds and pay their coupons, they are not paying inflation adjusted coupons. Those are nominal cash flows. Now, inflation (and inflation expectations) may affect the coupon rate, which is generally determined by the market.
But that actual coupon is not inflation adjusted, it is nominal.
Finally, stock prices and free cash flows are also nominal. We don’t see stock tickers adjusted for inflation (though sometimes reported returns are), and companies themselves don’t adjust their earnings or free cash flows to the value of the dollar against purchasing power.
That means that most WACC calculations are nominal, which means most DCF valuation models should also be nominal.